Applying Real Option Theory to Software Architecture Valuation

1
Applying Real Option Theory to Software
Architecture Valuation

• Yuanfang Cai
• University of Virginia

2
Outline

• Issues that are Unsolved by Information Hiding
• Options What and Why?
• Summer Efforts
• Real Options in Avaya
• Summary and Discussion

3
Issues that are Unsolved by Information Hiding

• Difficult Justification of the Cost
• Predict future
• Study the commonality among family members
• Time/Quality Dilemma
• Future Prediction Never Happens
• Taken Software Design as an Investment Activity,
  What are the Values of Information hiding
  Infrastructures?

4
Current Valuation Practices and their
Insufficiency

• Valuation by Products
• Discount Cash flow (DCF)
• Present Value Future Value/(1 k)t
• k Risk Adjusted Discount Rate
• t Project Time
• Decision Tree Analysis (DTA)
• Each possible outcomes in each time period is
  treated as a branch
• Probabilities of each outcome are estimated
• Backward Dynamic Programming
• Why They are not Suitable for Product Line
  Architecture Valuation?
• DCF Operational Flexibilities are ignored
• DTA Fixed Discount Rate

5
Options What and Why

• Financial Origin
• Financial Options give investors the right
  without symmetry obligation to buy/sell stocks at
  a predetermined price (exercise price) before/at
  a preset time (expiration time).
• From Wall Street to Main Street
• Real Options give investors the right without
  symmetry obligation to take an action at a
  predetermined cost (exercise price) at a certain
  point of time (expiration time).
• Options Way of Thinking Risk Management Strategy
• Uncertainties create opportunities
• Create Options to manage risks and master the
  upside
• Make minimal investment at the beginning and make
  incremental investment stage by stage

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Options What and Why

• Early Exploration of RO Application in Software
  Architecture
• Modularization create portfolios of options
• Information hiding gives the rights without
  symmetry obligation
• Product Line Strategy implies Options way of
  thinking
• Why Option Pricing in Financial and Real Option
  World?
• Why Option Valuation in Software Infrastructure?
• Black-Scholes Option-Pricing Model

7
Options What and Why

• Black-Scholes Option-Pricing Model
• C(S, ? E) SN(d1) Ee- ? rN(d2)
• d1 (ln(S/E) (r 1/2?2) ?)/ (? ?1/2)
• d2 d1 - ? ?1/2
• Key Elements in the Model
• S Underlying asset value
• E Exercise price
• ? Standard deviation of the rate of return
• ? Expiration time
• r Risk free interest rate
• C Option premium/option price

8
Examples that Show Differences
Non-Phased Development vs. Phased Development

• A Project Business Case
• Five years
• Total Investment 11 Million
• Expected Cash Flow in year 5 21 Million
• Non-phased development
• NPV computed by Traditional DCF (worst case)
  1mm
• Phased Development
• Phase 1
• First year I15 Million
• The expected Net Cash flow from Local
  Distribution V1 5 Million
• NPV of phase 1 is 0

9
Examples that Show Differences
Non-Phased Development vs. Phased Development

• Phased Development
• Phase 2 (option)
• The second outlay in 3rd year I26 Million
• The expected Net Cash flow from expanding
  Distribution V2 15 Million
• The Uncertainty of V2 ? 0.5
• Value of the Option 10 Million
• Expanded NPV NPV of phase 1 option premium of
  phase 2 10 Million

10
Summer Efforts

• Applicability of RO Valuation to Software
  projects
• Recognizing Options in Software Product Line
• Data Collection for Valuation on Real Projects

11
Applicability of RO Valuation to Software Projects

• Assumptions
• Stochastic Process
• No-arbitrage equilibrium
• Existence of traded securities to replicate the
  payoff to options
• Communication with RO community

12
Recognizing Options in Software Product Line
engineering

• Identify Options
• Deferrable, Expiring, Compound and Simple
• S Underlying asset value
• Net cash flow from family members
• E Exercise price
• Cost of building new family members
• ? Standard deviation of the rate of return
• ? Expiration time
• Project terminal year
• r Risk free interest rate
• C Option premium/option price
• The Value of the product line infrastructure

13
Real Options in Avaya

• Fertile Fields
• The Need for Real Options Valuation is recognized
• Most Data are available
• Sterile Fields
• Data are hard to get
• Insights into Business Data must be improved
• Established Ways of thinking

14
Summary and discussion

• Justification of applicability to software
  architectures
• Identification of options in software
  architectures and product line engineering
• There is a big gap between architecture side and
  business side
• Quantification and Ways of Thinking